The Tax Basics: Mutual Funds

First time investing in mutual funds?

Congrats! That’s exciting stuff. You’ve officially joined the ranks of hundreds of thousands by taking part in a diversified, professionally managed investment vehicle.

Of course, as with any new financial foray, you may also have some new questions. A broker or a savvy friend can handle some of them. But it never hurts to do some research on your own.

As an experienced tax prep company, we’ve fielded a ton of questions from first-timers in the mutual fund game—and for good reason! The IRS taxes mutual funds uniquely, and they differ slightly from stocks, bonds, ETFs, and other financial products.

A difference in investment often translates to a difference in taxes.

With that in mind, we’re going to ask—and answer—some of the most commonly asked questions regarding mutual funds. Ready, set, go!

What are mutual funds, exactly?

If you’re new to investing, you probably aren’t all that familiar with mutual funds in the first place.

Even if you’re familiar with mutual funds already, you should still take a second for a refresher. The IRS taxes mutual funds uniquely compared to some other financial products in large part because of their structure.

Simply, mutual funds are professionally managed pools of investor money. A mutual fund will gather money from hundreds or thousands of investors and invest it into a portfolio of financial securities. Each fund has a specific portfolio of researched, structured, and maintained assets to reach certain objectives.

For example, a mutual fund may deal exclusively in a specific group of stocks, or it may operate in stocks and bonds within an industry. Others match a specific market index, like the S&P 500. These portfolios often work with a certain risk profile in mind, such as a riskier, high-yield portfolio, or a low-yield, low-risk one.

Mutual funds can offer access to the kind of professional management typically accessible only to larger investors. Ultimately, since your money has been pooled alongside thousands of other investors, you share some of the risk as well as some of the profits.

How does the IRS tax on mutual funds?

Every investor is hoping to make money, but acknowledges they may well end up losing it, instead. Risk is inherent to all investments, including mutual funds and everything else that may be making up your portfolio.

Should your mutual fund investments go up in value, you’ll need to report it to the IRS and pay taxes on it, but the exact rates and codes that apply will vary somewhat from mutual fund to mutual fund—and they’ll typically differ somewhat from how you might be taxed on a simple ETF.

The exact differences will depend on the type of securities in the mutual fund’s portfolio. As an example, you may have invested in a mutual fund comprised of a handful of high-performing stocks along with some fixed-income government bonds, all of which have made various gains. Along with these gainers, perhaps a few stocks have underperformed. The successes and failures translate to profits and losses; any profits stemming from the mutual fund will typically result in a distribution.

What makes mutual funds so unique from a tax perspective is that once you have received some profits, you’ll be taxed either at the income tax rate, the capital gains tax rate, a combination of the two, or on occasion, not at all.

Capital Gains Tax vs. Ordinary Income Tax: What’s the difference?

Usually, the IRS taxes investment income at one of two rates: ordinary income tax and capital gains tax.

Depending on the size of your investment and how much money you’ve made, the difference between the income tax rate and the capital gains tax rate can translate to thousands of dollars or more!

• The ordinary income tax rate typically applies to income from investments held for less than a year. This rate is higher.
• The capital gains tax rate typically applies to tax income from investments held for a year or longer. This rate is lower.

Here’s why the differences matter here.

You aren’t actually taxed based on how long you have held your investment in a mutual fund. Instead, you’re taxed based on how long your mutual fund has held its investment in a specific security. So, you may have held your money in a mutual fund for three years without touching it. But if that fund purchases and sells a security within a year, the distributions you make will be taxed as ordinary income—not at the lower capital gains rate.

Which income from mutual funds is taxed at which rate?

Taxes on profits from mutual funds are certainly more complicated than for most securities, but fortunately, you won’t have to do all that much work figuring out which income is taxed at which rate. If your mutual fund makes distributions to you, it will give you a full breakdown on Form 1099-DIV with your other tax forms.

What if I still have questions?

Professional money management is an advantage of working with a mutual fund, but you shouldn’t stop there. It’s always wise to get in touch with a financial advisor or tax attorney help you tease through all this come tax season. If it’s your first time investing with a mutual fund, it can be easy to make a mistake. That mistake might lead you to face an unexpected tax bill or IRS audit.

It happens more than you think! And we hate to see it.

Whether you just need a helping hand to navigate your first mutual fund investment or you’re building your wealth for the long term, it’s a smart idea to add some reliable, expert professionals to your financial team.

It will pay off in the long run. Literally.

A little less hassle, a little more fun.

When tax time rolls around, the same advantages that make mutual funds so attractive—a researched, diverse portfolio of securities that balances risk—make them even trickier to understand.

But just like every investment carries risk, every tax return carries risk, too. At Edge Financial, we think your tax return is the last place to take a risk.